Easy money won't save Corporate America

Commentary: Lower taxes and spur trade to get U.S. economy moving

By

S.P.Kothari

Reuters

BOSTON (MarketWatch) — Since the onset of the global financial crisis in 2007-08, the administration and the Federal Reserve have implemented policies explicitly designed to spur investment, grow GDP, and reduce unemployment. These actions haven’t worked — certainly not as expected.

The weapons of choice to boost the U.S. economy have been low interest rates, deficit spending, and increased money supply through the Fed’s balance-sheet expansion to over $3 trillion. Yet almost five years later, GDP growth has been anemic at below 2% and at times negative, and aggregate domestic investment is about where it was in 2004, and considerably below the 2006-2007 level.

Are ‘too big to fail’ banks really safe?

Optimists believe it’s still too early and that we have spent too little. More of the same would eventually produce good fortune — at least, that’s the hope.

There’s one big problem with that hope. Research analyzing six decades of macroeconomic data suggests aggregate corporate investment responds relatively little to interest rates, but reacts (in fact overreacts) to profitability, economic outlook, and business and investor confidence.

U.S. corporate investment — one of the key engines of American economic growth — is largely dependent on how companies view their future profitability outlook, and has little to do with short-term interest rates or the availability of credit. Read more: The behavior of aggregate corporate investment.

Of course, low interest rates as a stimulant for investment and growth is not a new concept. Low interest rates reduce the cost of financing investments, especially consumer durables and corporate capital investment, which should manifest in increased investments.

Increased investment has many ripple effects, including rising employment and consumer spending. Collectively, these would translate into economic growth.

Unfortunately, the magic has not worked recently. To begin, it’s critical to understand why interest rates are low in the first place. Demand for investments following the crisis has been weak, so to clear the mountain of available capital, interest rates have to be low. That is, to a large extent, the Fed has been chasing low interest rates in an adverse economic environment, rather than the low interest rates being the result of Fed policies.

The Fed might have actively pushed the interest rate even lower, but incremental slashing of the interest rate is hardly sufficient to overcome managers’ reluctance to invest when the economic outlook is cloudy. An individual wallowing in low pay and worried about job security is unlikely to buy a home or a car just because the Fed has dropped the interest rate by a percentage point or two. Similarly, artificially depressing interest rates is unlikely to overcome CEOs’ fear of making a bad investment when demand is weak.

Missing piece

This begs the question: Why did this policy work in the early 2000s? The Fed lowered interest rates rapidly after 9/11, and soon thereafter the economy turned around, recording impressive GDP growth. What was different then?

Easy credit is the missing piece. Coupled with low interest rates, the administration and the Fed at the time opened the credit spigot (in part through Fannie Mae and Freddie Mac). The housing market took off like a rocket and propelled the entire economy to what proved to be unsustainable heights. But, for a while, all of us were Keynesians and devotees of trickle-down economy!

The party, however, came to a crashing halt once credit repayment failed and the housing bubble burst. That is, easy credit fostered an artificial economic growth that was impossible to sustain.

Fast-forward to now. Interest rates have been low, but mortgage credit is not easy anymore, so there’s no housing market miracle. Corporations have not swung into action with the lure of low interest rates and made investments.

But the student loan market is deja vu all over again. Federally guaranteed student loans have doubled in just four years to almost a trillion dollars and their default rates now exceed the default rates on credit card loans. Return on college investment is much lower now — this is because easy credit is leading to bad investments. Without market discipline, it’s possible to significantly overinvest.

Naturally, college degrees would seem worth less now than before. The same can be said about housing investments made in the early 2000s — easy credit corrupted investment behavior and distorted housing prices leading to the wrong conclusion that housing investments are bad.

What’s the solution? The administration’s foremost priority should be to foster an economic environment conducive to corporate investment, that is, improved profit outlook for companies. Enacting fair and stable regulatory, labor, and international trade policies, lowering taxes, and facilitating interstate competition, for instance, would likely encourage private sector spending.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information. Intraday data
delayed per exchange requirements. S&P/Dow Jones Indices (SM) from Dow Jones & Company, Inc.
All quotes are in local exchange time. Real time last sale data provided by NASDAQ. More
information on NASDAQ traded symbols and their current financial status. Intraday
data delayed 15 minutes for Nasdaq, and 20 minutes for other exchanges. S&P/Dow Jones Indices (SM)
from Dow Jones & Company, Inc. SEHK intraday data is provided by SIX Financial Information and is
at least 60-minutes delayed. All quotes are in local exchange time.